Here's an interesting exchange with an AIG executive from the FCIC interviews. As I explained a while ago, what really killed AIG were the terms of its CDS contracts on subprime CDOs and RMBS — specifically, the contracts included Credit Support Annexes (CSAs) which required AIG to post collateral based on the mark-to-market value of the underlying CDOs. When the CDO shut down in 2007, mark-to-market prices collapsed as well, forcing AIG to post tens of billions in collateral on their CDS contracts.

In the FCIC's interview with Andrew Forster (mp3), who headed AIGFP's London branch, the interviewers — to their credit — actually directly asked asked Forster about this. His response is fascinating. The two FCIC interviewers were Chris Seefer and Dixie Noonan, and I've transcribed the exchange to the best of my ability, since it's pretty short: (emphasis mine)

Chris Seefer (FCIC): Did you know that the contracts for the multisector [CDS] book included terms that would require AIGFP to post collateral if there was a decline in the market value of the reference collateral?

Andrew Forster (AIG): Um, as I've looked back over my emails and notes, it's clear that there were times that I was copied on an email that would have that sort of information. Did I recall that? Did I look at it? No, I didn't. But it would be disingenuous for me to say that I clearly had no knowledge of it, because I must've, I should've had some back at that time. But it wouldn't really have rang any great — it wouldn't have resonated with me on the basis that my understanding was pretty much every derivative product that you write is gonna come with a CSA and a collateral agreement. That's just the market standard. So it wouldn't be odd if that was the case. But the exact specific terms of the different ones, no, I didn't really focus on it at the time.

...

Dixie Noonan (FCIC): You said that it was typical for the contracts to have collateral provisions. Was it typical, based on your understanding at the time, for the collateral provisions to be based on declines in the market value of the underlying securities?

Andrew Forster (AIG): Yeah I mean a typical derivative, or any credit derivative, they would all come — my understanding is that the market standard would be that that came with a CSA agreement and a collateral agreement, and that would be based on some estimate of market value for those products.

Dixie Noonan (FCIC): And would that be true not just for asset-backed security CDOs, but also for corporate CDS?

Andrew Forster (AIG): Yeah, I mean we wrote lots of other single-name corporate CDS. If you write one of those, it all comes with a collateral — I mean, 99% of the time it's gonna come with a collateral agreement. And it's based on the, you know, replacement value, or something like that, for the product.

OK, to be clear, it's simply not true that the "market standard" was for CDS on asset-backed securities to include full-blown CSAs, which require counterparties to post collateral based on mark-to-market prices. The only other big protection sellers for CDS on asset-backed securities at this time were the monoline insurers, which did not post collateral based on market prices. (The monolines did, however, agree to post collateral when their credit ratings were downgraded, but that's another story.) Whether protection sellers would have to post collateral based on market prices was a fairly contentious and prominent issue, and yet Forster was apparently unaware that a debate even existed. To him, CDS on asset-backed securities were just another derivative, and since most derivatives included full CSAs, CDS on asset-backed securities should naturally include CSAs too. (It sometimes took weeks to negotiate CSAs for bespoke derivatives, so I don't know why Forster thought all these deals should just include routine CSAs.)

Of course, there's a reason why the collateral-posting issue for CDS on asset-backed securities was so contentious: because a full CSA exposes the counterparties to significant market risk. So if you're a protection seller on a CDS, you would specifically want to avoid a full CSA when the underlying security trades in a particularly illiquid market, where prices jump around a lot, because that could require you to post large amounts of collateral on very short notice. AIG learned that the hard way.

That Forster gave this really very fundamental issue so little thought is just amazing.

25
comments:

Anonymous
said...

I was under the impression the monolines posted collateral for downgrades only on their GIC book, not their CDS book.

I've read that AIGFP's CSAs only required posting collateral if AIG's credit rating fell below AAA. In fact, that was the whole reason for the existence of AIGFP -- to monetize AIG's AAA rating by being able to write CDSs with CSAs without having to hold reserves against the possibility that collateral might be required. When AIG lost its AAA rating in 2005, AIGFP turned into a time bomb. (And it appears to have taken most of 2005 for AIG management to get around to shutting down AIGFP's sales operation.)

My memory could be hazy, but I thought AIGFP had ratings-contingent CSAs on their bespoke structured CDS book. I thought this was what gave rise to such massive, all-at-once demands for cash from their counterparties (GS et al.), sparking the liquidity concerns that ultimately led to the Fed intervention. Don't recall where I got that from. Was this in Sorkin's "TBTF", do you know?

Sandrew, you are right, the largest amounts of collateral only fell due after downgrades, hence the bailout was only neccessary after AIG got downgraded (although some C/Ps such as Goldman were do collateral even when AIG was AA or higher, though perhaps not at AAA)

In Fatal Risk, Roddy Boyd's 'autopsy' of AIG's collapse he had this to say about the CSAs.

"When the agreements went out, they had CSAs attached. Every swap Godlam did, with everyone from small hedge funds to AIGFP, had a CSA attached. There was no negotiating on it or the term of the CSA, which was industry standard anyway. The bottom line was that Goldman marked everything to market at least once a day, so the underlying asset, the so-called reference security, would be subject to their determination of prices. After all, since Goldman was the middleman most of the time, they would also be making collateral postings to their counter party.

It was all pretty cut and dried. Frost returned the signature sheet a few days after the swap agreement arrived in Wilton with no questions asked and the swap was on"

"But Jake Sun, the general counsel of the Financial Products subsidiary, who reviewed the swap contracts before they were executed, told the FCIC that the provisions were standard both at AIG and in the industry. Frost, who was the first to learn of the collateral call, agreed and said that other financial institutions also commonly did deals with collateral posting provisions."

Sandrew, you are Cheapest wow goldcorrect, the most significant levels of equity only chop down due after downgrades, for this reason the actual bailout only agreed to be needed after AIG received cut down (while many C/Ps such as Goldman have been perform collateral even when AIG ended upCheapest Diablo 3 gold being AA or higher, even though probably not necessarily in Ccc)

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About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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